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April 1, 1995THE INSTITUTIONAL FOUNDATIONS OF ECONOMIC REFORMS Page 1

THE INSTITUTIONAL FOUNDATIONS OF ECONOMIC REFORMS: THE CASE OF CHILE


by

Vittorio Corbo, Rolf Lders and Pablo T. Spiller April 1, 1995 A

Corbo and Lders are Professors of Economics, Universidad Catlica de Chile, Spiller is Visiting Professor of Business and Public Policy, University of California, Berkeley. Spiller acknowledges support from the Global Operations Program at the University of California. David Decker provided able research assistance.

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I. Introduction Looking at Chile's aggregate economic and social statistics since the 1970s (see Table I:1), one cannot but wonder what has made Chile different from the rest of Latin America. Indeed, if we look at Chile's statistics from the post war till the Allende period (see Table I:2), Chile does not look that different from its neighbors, like, Argentina, Colombia and Uruguay. It is tempting to say that the dismantling of the protectionist state and the creation of a market economy during the regime of General Augusto Pinochet is at the source of this transformation. We believe that the answer is deeper and more complex. Although the reforms that were undertaken during the Pinochet regime are behind the transformation of Chile from a sleepy South American country into the only, so far, Latin American tiger, the main thrust of this paper is that just the opening of markets would not have been enough. What took place in Chile was a drastic institutional transformation that provided the reforms with a lasting power and thus the required credibility to promote private investment. This transformation has three basic features: first, the Chilean reformers systematically (and we are tempted to say purposely) diminished the discretion of the government in the administration and implementation of stated policy objectives; second, the Chilean reformers complemented the economic reforms with social and political reforms that systematically diminished the ability of the government to undertake unilateral changes in governmental policies; and finally, the Chilean reforms were undertaken in the shadow of an institutional setting which provided for direct enforcement of the above constraints on governmental decision making. Indeed, these three conditions satisfy what Levy and Spiller (1994) call the three complementary mechanisms to provide credibility and effectiveness to a generic regulatory framework --and hence to facilitate private investment. The main purpose of these three complementary mechanisms is to restrain arbitrary administrative action. As discussed in Levy and Spiller (1994), the Chilean reformers chose policy

If at all, one wonders why Chile was performing worse than its neighbors. See, Green, D., "Chile: The First Latin American Tiger?", NACLA Report on the Americas, v28, n1 (July-August, 1994), p.12-17. 1 This is what Douglass North would call, setting the prices right. See North (19xx).

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credibility over policy flexibility. Indeed, as we will see, in several instances credibility had its costs as reversing some of the chosen policies that turned out to be impractical or inappropriate was very hard to achieve. In this paper we focus only on a selected set of reforms, and we analyze how these reforms seem to have been undertaken so as to limit the potential for governmental administrative discretion, as well as for reversals by future governments. Thus, we will find that Chile's regulation of public utilities is based on very specific legislation so that utility regulators have very little discretion on pricing and on which areas to be regulated; that the appointment process to the antitrust commission is such as to limit potential influence by either the government or the legislature; that the central bank is similarly organized so as to limit the influence of politics on monetary policy; that the pension schemes links the interests of the working men and women to that of Chile's companies; and that the welfare system was designed so as to limit its manipulation for political reasons. Overall the reforms seem to have had the intended effects. Although on some dimensions the Asian tigers still outperform Chile (e.g., Chile's savings are a few points below that of the Asian tigers), its institutional framework seems to place it on a different and higher level. Chile's reformed institutions limit government discretion, make difficult any drastic shifts in policies, providing, then, commitment to a market economy and encouraging private investment. What makes Chile different is that the commitment to the economic reforms is based on the subtle interplay of economic and political institutions rather than on the particular personalities of the party leader or president of the day, thus providing a more stable and credible investment environment. The purpose of this survey is to provide an in-depth analysis of its policies since the 1970s with emphasis on the nature of its institutional design. We start with a brief historical background, followed by a short analysis of Chile's institutions and its implications for policy determination and by an in-depth analysis of some of the more interesting, and less analyzed, of the reforms.

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II. Economic Background The Chilean Economy at the end of the sixties. By the end of the sixties the Chilean economy was dominated by a very large and intrusive public sector, and experienced almost twenty years of what today may be called moderate inflation: annual inflation in the range of 30 to 40 percent. Relative prices of tradable goods differed much from foreign prices through the widespread use of tariff and non-tariff trade barriers. Price controls were widespread, and the financial sector was repressed through the use of controls on nominal interest rates with real deposit rates at times becoming negative. This state of affairs was the result of the implementation of an aggresive import substitution industrialization strategy (ISIS) that started in the late 1930s as an answer to the world depression, and that was later pursued as a development model under the influence of Raul Prebisch and the ECLA. To pursue the ISIS, a battery of instruments were used, including trade incentives, the creation of large public enterprises in the steel, oil, petrochemical, power, and other sectors. The government also intervened trough the allocation of credit and the granting of subsidies. In the early "easy stage" of import substitution growth picked up, but then faltered in the second half of the fifties. By this time Keynesian ideas were making their way in the region, and aggregate demand policy was used to restore growth only to encounter chronic balance of payments and inflation problems. Some attempts at stabilization and liberalization of the trade regime were made during the Alessandri (1958-1964) and Frei (1964-1970) administrations. The initial attempts failed as the fixed exchange rate that was used to anchor the stabilization effort had to be abandoned as it was incompatible with the governments macroeconomic policy and, as a consequence, a large real appreciation developed. The Frei administration introduced indexation mechanisms as ways of reducing the relative price distortions associated with moderate but variable inflation, but the trade liberalization effort of the second half of the period was also abandoned
b because

of strong political opposition.

This section is based on Universidad de Chile (1963), Corbo (1974), and Ffrench Davis (1973). See XXXX (19xx).

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The Chilean Economy During The Allende Years. The Allende administration (November 1970-September 1973) tried to apply a fairly radical transformation of the economy, expanding drastically the role of the state in the control of production and distribution of goods and inputs. In pursuing this objective the banking system and a large part of international trade activities were nationalized. Furthermore, as the government lost control of aggregate expanditures through a series of populist policies, price controls were established to avoid the emergence of open inflation. The isolation from the world economy reached its peak during this period. The average nominal import tariff was 105%, with tariffs ranging from nil for some inputs and "essential" consumer goods to 750% for goods considered as luxuries. There were also many non-tariff barriers, including the requirement for a 90-day non-interest bearing deposit amounting to 10 times the import value, import and export quotas, prior approval for all types of imports, and multiple exchange rates. By 1973, there were six widely different exchange rates, with the ratio between the highest and the lowest being 52 to 1. As a direct result of the system of protection, export activities were heavily taxed. Not surprisingly, imports were concentrated on intermediate goods, followed by capital goods, and a few "essential" consumer goods. Export earnings became almost entirely dependent on copper exports and prices. Private capital inflows almost totally vanished. The government, directly or indirectly, took control of a large part of productive activities. The agrarian reform, initiated in the Alessandri administration (1958-1964) and intensified during the Frei administration (1964-1970), was drastically accelerated during the period, and all large states were practically dismembered. The banking system was nationalized. In other sectors of the economy private businesses were taken over by workers' councils, or alternatively company shares were bought by the government to extend what was then called the area of social
This section is based, in part, on Cauas and Corbo (1972), Bitar (1986) and Larran and Meller (1991). As the government could not pass the required expropriation law to take over the property of the banks from the previous shareholders, it offered attractive prices to buy the shares in the open market. This process took place mostly in 1971. By 1972 almost all the banking system was in public hands. CITE

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property. Multinationals were expropriated, in some cases, as with copper enterprises, without compensation. This brought the government into conflict with various foreign governments, especially with the US. On the macroeconomic front, the Allende government pursued populist policies. In 1971, current government spending grew by 12.4 per cent in real terms, and the fiscal deficit reached 10.7 per cent of GDP. Fueled by this aggressive demand expansion, GDP grew 9 per cent in real terms in 1971 (Table 1). In the same year, the money supply grew by 66 per cent in real terms -- a result of the large growth in high powered money to finance the rising public sector deficit, and the inertia of prices. Measured inflation in 1971 was relatively low, but price controls and commodity and factor market rationing became widespread. During the following two years, the government continued its expansionary policies. The fiscal deficit rose from 2.7 per cent of GDP in 1970 to almost 25 per cent of GDP in 1973. The monetization of the deficit and import controls put pressure on domestic prices rose. Tighter price controls were introduced, resulting in the development of active black markets for both final and intermediate goods. There was a progressive deterioration of the current account deficit, which reached 3.9 percent of GDP in 1972 (see Table 1). The large foreign reserves inherited from the Frei administration financed the current account deficits of 1971 and 1972, but by August 1973 the reserves were exhausted, and the stage was set for a major balance of payments crisis. Economic Policies During the Military Government The government that took power in September 1973 inherited an economy closed to international trade, dominated by the public sector, with accelerating inflation and a massive current account deficit. Relative prices were severely distorted and the production and distribution of goods were determined mainly by bureaucratic rules. The labor market was dominated by a few organizations which were fighting for political rather than workers' objectives. The country had practically no foreign exchange reserves and the nonfinancial public sector had a deficit of close to 25% of GDP (Table 1) One of the main objectives of the military government that took power in September 1973, was to
On the reforms of the Pinochet regime see Corbo(1985), Edwards and Edwards(1987), Harberger(1985) Meller(1990), and Wisecarver (1992).

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eliminate the severe macroeconomic disequilibria that it inherited and to reestablish a market economy. The reduction of inflation required a deep structural reform of the public sector to reduce the size of the public sector deficit. To restore the role of the market as the main agent of economic development the Military government undertook a major revision of public sector responsibilities, involving a drastic reduction in the size of this sector and in its participation in economic activities, and a deregulation of commodity, financial, and labor markets. The initial 18 months of the new administration were spent in liberalizing prices and in initiating a deep fiscal reform. By 1975, there emerged within the government, a team of economists with very strong liberal ideas, which was dedicated to transforming Chile into a competitive, market oriented, open economy. Towards this end, reforms were initiated in eighth main areas: (1) a stabilization program to reduce an increasing inflation that was reaching a rate of 1000% per year; (2) public sector reforms with the purpose of achieving macroeconomic stability and improving the efficiency of the public sector and its implications to the economy as a whole; (3) trade reforms to reverse the existing level of protection and to open the economy; (4) a social security reform to change from a pay-as-you go pension system into one based on individual capitalization; (5) financial sector reform; (6) labor market reform to facilitate the drastic reallocation of labor that had to take place from the highly protected import competing sectors towards the export oriented activities; (7) a comprehensive privatization program; (8) regulatory reform is the basic utility sectors; and (8) social sectors reforms to improve the incentive system in the production and provision of social services and to target the provision of social programs to the poorest groups in the population. To these major economic reforms, the military government, through a series of popular votes, introduced major constitutional reforms that changed the way members of parliament were elected, modified the balance of powers among the different branches of government and, in general, introduced substantial checks and balances in the work of the government. The economic and social implications of the policies pursued by the Military regime have been

See next section.

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discussed at large elsewhere and we will not repeat them here. Table 1 shows, however, that by the second half of the 1980s Chiles economy was growing at an annual average rate of more than 6%, a very rapid pace for the region. Furthermore, its exports were diversified, its rate of investment and savings were high for the region, and unemployment levels fell from the high level that characterized the early part of the Military regime. It is in this macroeconomic environment that a democratic government was reinstituted.

Economic Policies in the 1990s. The democratic government that came to power in March 1990 inherited an accelerating rate of inflation (Figure 1), which had reached 27.3% in 1989, the highest level since 1980. The new government, which was expected to increase attention to social issues, was faced with the immediate task of slowing down inflation and conveying the message that maintenance of macroeconomic balance would be one of its main objectives. Furthermore, it had to announce its views on the economic model introduced by the Pinochet administration. The newly independent board of the Central Bank implemented from the beginning an aggressive stabilization program based on a sharp increase in real -- CPI indexed --interest rates on Central Bank paper. Real interest rates on 10 year Central Bank paper were raised 230 basis points, from 6.9 to 9.2 percent per year. The resultant slowdown in real expenditures contributed to a reduction of GDP growth, to an increase in the trade balance surplus, and to lower inflation. However, in a world of increasingly integrated capital markets, a high real interest rate policy pulls in foreign capital that tends to offset the desired contractionary effects of the interest rate increase. Not surprisingly, in 1990 the Central Bank ended up accumulating 2.4 billion dollars in reserves. The issuing of Central Bank debt to finance the reserve accumulation increased Central Bank losses, as the Central Bank in effect borrowed at high domestic interest rates to invest abroad at
l lower

rates adjusted for exchange rate changes.

See CITE

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On the structural reform side, the Alwayn (1990-1994) and Frei (1994-) administrations embraced a substantial part of the model developed during the Pinochet regime, and by now the model of an open economy pulled by private initiative has achieved a large support across the different sectors of the chilean society. A major thrust of this paper is that the institutionalization of the reforms implemented during the Pinochet years played a central role in the building of the new economic model. To these major economic reforms, the military government, through a series of popular votes, introduced major constitutional reforms that changed the way members of parliament were elected, that shifted the balance of powers among the different branches of government introducing substantial checks and balances in the work of the government. In this paper we do not intend to provide a comprehensive discussion of the different reforms. Instead we will focus in detail on a few to highlight how they seem to have been designed so as to provide commitment to a market based economy through limits on the discretionary powers of the government. Before discussing the institutional nature of the economic reforms, it is important to discuss the institutinal environment in which they took place.

III. Chiles Institutional Background and Its Implications for Economic Reforms Following Levy and Spiller (1994) and North (1990), we define the institutional endowment of a nation as comprising five elements: First, a country's legislative and executive institutions. These are the formal mechanisms a) for appointment of legislators and decision makers, for making laws and regulations, apart from judicial decision making; b) for implementing these laws, and c) that determine the relations between the legislature and the executive. Second, the country's judicial institutions. These comprise its formal mechanisms a) for appointing judges and determining the internal structure of the judiciary; and b) for impartially resolving disputes among private parties, or between private parties and the state. Third, custom and other informal but broadly accepted norms that are generally understood to constrain the action of individuals or institutions. Fourth, the character of the contending social interests within a society, and the
C Citation

to survey studies.

This section is partially based on Levy and Spiller (1994).

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balance between them, including the role of ideology. Finally, the administrative capabilities of the nation. Each of these elements is subject to change, and indeed, as we will see, some of these institutions were changed by the nature of the economic and political reforms of the 1970s. The form of a country's legislative and executive institutions influences the credibility of its policies. The crucial issue is to what extent the structure and organization of these institutions impose constraints upon governmental action. The range of formal institutional mechanisms for restraining governmental authority includes: the explicit separation of powers between legislative, executive and judicial organs of government; a written constitution limiting the legislative power of the executive, and enforced by the courts; two legislative houses elected under different voting rules; an electoral system calibrated to produce either a proliferation of minority parties or a set of parties whose ability to impose discipline on their legislators is weak; and a federal structure of power, with strong decentralization even to the local level. Governmental policy is likely to be far more credible in political systems that constrain executive and legislative discretion. Note, however, that credibility is often achieved at the expense of flexibility. The same mechanisms that make it difficult to impose arbitrary changes in the rules may also make it difficult to enact sensible rules in the first place, or to efficiently adapt the rules in the face of changing circumstances. For almost all its modern history, Chile has been a representative democracy. The period between 1973 and 1989, when Chile went through a period of military rule under General Augusto Pinochet stands out
For analysis of the role of separation of powers in diminishing the discretion of the executive, see Gely and Spiller (1990) and McCubbins, Noll and Weingast (1987, 1989), and references therein. ( Non-simultaneous elections for the different branches of government tend to create natural political divisions and thus electoral checks and balances. See Jacobson (1990). For an in-depth analysis of the determinants of the relative powers of o the executive, see Shugart and Carey (1992). Electoral rules have also important effects on the "effective number of parties" that will tend to result from elections, and thus, the extent of governmental control over the legislative process. For example, it is widely perceived that proportional representation tends to generate a large number of parties, while first-past-the-post with relatively small district elections tends to create bipolar party configurations. This result has been coined Duverger's Law in political science. See Duverger (1954). More generally, see Taagepera and Shugart (1993). For analyses of how the structure of political parties depends on the nature of electoral rules (with applications to the UK) see Cain, Fiorina and Ferejohn (1987) and Cox (1987). ( On the role of Federalism in reducing the potential for administrative discretion see Weingast (1993) and references therein.

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as a 16-year exception to over 100 years of rule by civilian government. For the rest of this 100- plus year period, the country has been governed by a constitution that embodied the principles of separation of powers, orderly transfer of authority, and regular elections between competing parties. For an extended period, electoral rules were such that voters were, and still are, divided among multiple parties, with none strong enough to govern or legislate, except by coalition. As a consequence, legislators' independence from central party apparatus developed a legislature with a strong sense of local representation. A series of constitutional reforms between 1958 and 1973 shifted the balance of authority in favor of the presidency and elevated national (rather than regional) politics and parties to center stage. These reforms granted more executive powers at the same time that they developed stronger checks and balances. The reforms increased the potential for conflict between the legislative and the executive branches, which became evident during the regime of President Salvador Allende. Thus, while not completely resistant to extreme pressure, we see Chile's longstanding set of legislative and executive institutions and the nature of its checks and balances as potentially providing some credible safeguards against arbitrary changes in government policies. This period of extended stability, broken only by the military takeover in 1973, developed in Chile a strong respect for institutions. To understand the subtle nature of Chile's checks and balances, it is useful to discuss in some detail the nature of its formal political institutions, namely, the legislature, the executive, and the judiciary. Chile is governed by a President who is elected by a ballotage process for a six year mandate. Chile's legislature is
Although there were other brief periods of democratic breakdowns, the Pinochet regime was the longest. At the same time, concurrent elections provided for the development of bipolar coalitions that offered voters choices over national policies without the need to develop strong central parties (Shugart and Carey 1992, p. 174). o Shugart and Carey (1992, p. 183) call the system before the constitutional changes of 1958 and 1970 the "inefficient secret," as the regionalization of politics, and the relatively weak powers of the president, provided for a very dynamic legislature. Concerning the post-1970 Chilean system Shugart and Carey (1992, p. 200) describe it as the strongest among presidential systems. We discuss this issue further below. a One may ask whether this respect for institutions persisted even during the military regime of General Pinochet. Even then signs of respect for longstanding institutions are evident. For example, during the military regime the constitution was amended by a popular referendum. Similarly, the military regime's decision to return the country to a democratic system followed an electoral loss. s In February 1994 the Congress approved a reduction in the Presidential mandate from eight to six years. The President

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composed of two chambers. Senators are appointed for 8 years, while members of the Chamber of Deputies are appointed for 4 years. Fifty percent of the elected Senators stand for reelection every four years, while all Deputies must stand for reelection every four years. Elections are non-concurrent, so that, as in the United States, there are mid-term elections. The Senate is composed of 38 elected and several non-elected members. The electoral rules introduced prior to the 1989 referendum provide an advantage to the minority parties and a strong advantage to less populated regions. There are 60 districts for the Chamber of Deputies and 19 for the Senate. Each district sends to the legislature two deputies and two senators. Each district's seats are allocated based on number of votes for each party list. Unless the most voted list has more than double that of the second ranked list, the district will send a representative from the two most highly voted lists in the district. Thus, electoral rules provide strong incentives for the creation of alliances at the district level. On the other hand, presidential election rules (the ballotage) provide incentives for cross-party
c cannot

be reelected for a consecutive period.

Because presidential elections are every six years while parliamentary elections are every four years, mid-term elections may occur two or four years prior to the next Presidential election. m The non-elected members are: all living former presidents that served for six continuous years; two former Supreme Court Justices, to be appointed by the Supreme Court; a former Comptroller General, also appointed by the Supreme Court; four former Commanders in Chief, one respectively from the Army, the Navy, the Air Force and the National Police, to be elected by the National Security Council; a former University President, to be elected by the President of the Republic; and a former Minister of Economics, also appointed by the President. Currently there is no living former President in the Senate as Pinochet is still the Commander in Chief of the Army and Aylwin was President only for four years. The National Security Council is composed of the President, the Chief of the four branches of the military and the Comptroller General. C The referendum was voted on July 30, 1989 and the Constitutional Reform Law #18,825 was passed by the legislature in August 1989, prior to the first democratic elections of December 1989. The electoral rules of the 1925 constitution, however, provided a slight advantage to the majority party. Although the proportional representation system provided for one deputy for each 30,000 inhabitants, the electoral rule allocated remaining votes to the largest parties (rule of cifra repartidora or divisin comn), providing then a slight advantage. Thus, the Christian Democrats obtain in the 1965 election 55% of the seats in the Chamber of Deputies, with only 42% of the popular votes. e Consider a situation where ther are five independent candidates with the following percentage of popular support: 30, 25, 20, 15 and 10%. If each runs under a separate list, the two with the highest percentage will win. The third candidate, however, could win a seat if it would enter into a single two member list with the first candidate. In that case, the list consisting of candidates 1 and 3 would gather 50% of the vote, doubling the second most voted list. The second most voted candidate, however, could block such outcome by entering into a joint list with the fourth or fifth candidate. Such action, however, would not provide the latter two candidates with a seat but will block the third candidate from winning its seat. Thus, unless the second candidate promises something else in return for their support, the smaller candidates will have no incentive in joining in. Thus, the electoral system provides strong incentives for the creation of regional

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alliances at the national level. Electoral districts are of unequal size. For example, for the 1989 elections, District # 59 had 18,254 registered voters while district #18 had 102,540 registered voters. Even more extreme differences appear in Senatorial districts. For example, in the 1993 elections, 38,000 voters voted in Senatorial Region XI while in Region V-Coast, there were 380,000 voters. Thus, the most highly voted senator from Region V-Coast got 115,000 votes, while the most highly voted senator from Region XI got only 11,287 (both with 30% of the popular vote in the region). The upshot of the electoral rules is that regional representation is important for congressional elections, thus creating a natural fragmentation of parties. Indeed, in the current parliament, there are eight independent parties in the Chambers of Deputies (there are also four independent deputies), while six parties are represented in the Senate. The Senate also has three independent and eight appointed senators. The composition of the current congress shows the bias towards the minority parties inherent in the electoral rules. In the last elections the second largest party, Renovacin Nacional (RN), obtained 16% of the votes for the Chamber of Deputies, against 27% for the governing Partido Demcrata Cristiano (PDC). Nevertheless the RN holds 29 seats (or 24% of all seats) against 37 seats (or 30%) for the PDC. The executive has important but not extreme legislative powers. Indeed, the constitutional reforms of 1989 diminished the legislative powers of the president, by limiting the power of its partial veto (from no override to one with a 2/3 supermajority override), eliminated its decree powers, and eliminated the president's ability to dissolve the Chamber of Deputies. The President's main powers are in the realm of budgetary policy. Only the President may introduce legislation concerning taxes, expenditures, public debt, social security schemes (including private schemes), creating new public services and collective bargaining. Also, in budgetary, expenditure or employment legislation, the legislature may not increase any proposed

c coalitions

at the district level.

In the last presidential elections, which were concurrent with congressional elections, there were two main coalitions, a center-left and a center-right. The PDC was the leading party in the center-left coalition, while the RN was the leading party in the center-right coalition. There have not yet been mid-term elections since the end of the Pinochet regime as the constitution specified a transitory four year term for the first elected president. t See Shugart and Carey (1992).

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appropriation. The legislature may, however, delete or reduce any item in the proposed legislation. There is also a strong germaneness constitutional limitation on amendments as the legislature may not attach to a bill an item whose nature is unrelated to the bill in question. As mentioned, the President has a partial, or line item veto, which can be overruled only by a two-third majority in each chamber. The Supreme Court and the Appeals Court are strongly independent. Their members are appointed by the President from a slate proposed by the Courts themselves. Judges of the Supreme and Appeal Courts are appointed for an indefinite term, but must resign upon reaching 75 years of age. Thus, the Supreme Court, as in the United States, constitutes a strong source of stability, and to some extent, of "unpredictability," as it may side on important issues against the government. There is also a Constitutional Court which is in charge of determining the constitutionality of the actions of the executive and of the legislature. The Constitutional Court is composed of seven members who serve for eight years and who cannot be removed. The Constitutional Court is partially replaced every four years. The Supreme Court elects, in secret and successive ballots, three of the members of the Constitutional Court. The President of the Republic appoints a lawyer, as does the Senate. The National Security Council appoints two lawyers. Because of its composition, the Constitutional Court is another source of policy stability. Finally, Chile's checks and balances are further developed with the institution of the Comptroller General. Among other functions, the Comptroller General must approve on the legality of the administration's actions, including whether its decrees and resolutions (including budgetary resolutions) are in conformity with the constitution and the law. The Comptroller General is appointed for an indefinite term by
Chile's constitution also requires a partial balanced budget, as it prohibits the legislature from approving an expenditure increase without identifying the sources of funds needed for such additional expenditures. Also, the President is the only party that can provide an estimate of revenues. p The constitution even requires that if such amendment were to be voted upon, the proponents of the amendment and the President of the Chamber should lose their seats. P In the case of the Supreme Court, that slate must include the Senior Justice from the Courts of Appeal. This, however, does not mean that the Court will behave in a random fashion. Rather its ability to impose its will is constrained by the composition of the Chilean's legislature. But given the potential for legislative fragmentation discussed above, it is quite reasonably to expect that the Chilean Supreme Court has as much discretion as its counterpart in the United States. For a discussion of the determinants of judicial discretion see Gely and Spiller (1990).

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the incumbent President with a positive vote from the Senate and cannot be removed. The Comptroller General must resign upon reaching 75 years of age. Conflicts of a constitutional nature between the President and the Comptroller General are resolved through the Constitutional Court. Thus, the Chilean system has a strong set of checks and balances based on diffusion of power. While the executive holds the reign on key budgetary legislation, it will seldom control the legislature. Party and regional fragmentation implies that the legislature will not respond to a single party, and that parties themselves will not be that homogenous. Instead, the electoral system provides for electoral coalitions that, for congressional elections, will have a regional bias, while for presidential elections will have a national agenda flavor. Thus, as emphasized by Shugart and Carey (1992), the Chilean system may provide for gridlock, as legislation may not pass easily. Given that the initial conditions prior to the resumption of constitutional rule in 1989 were pro-market, the potential gridlock may translate into a strong signal of stability. Indeed, as we will see below, the reforms enacted during the Pinochet period were all introduced through extremely precise legislation, limiting the ability of future administrations to modify policies by decree, again providing credibility to the initial policy choice. Furthermore, the strong independence of the judiciary implies that attempts to amend policies through Presidential decrees will be checked by the courts. Indeed, over the years the Court has had a stand quite independent of the Government. For example, Salvador Allende's 1970-73 government repeatedly clashed with the courts over issues of expropriation and compensation, with the courts refusing to back down. By late 1972, however, the relation between the administration and the Supreme Court was severely strained, with the administration insisting on the validity of its actions, and the court just as firmly insisting otherwise. (Galal, 1994). Also, as we will see in the section
On non-budgetary non-constitutional issues, the President may insist on the legality through a formal decree signed by all its Ministers, in which case the Comptroller General must process the decree or resolution. On budgetary issues, however, the President cannot insist, and a determination of illegality by the Comptroller General is enough to kill the specific decree or resolution. (Constitution, Arts. 87-88). s In this respect it is interesting to mention that the constitution requires that all presidential decrees be signed by the relevant Minister, who is individually responsible for all the acts under its signature and jointly and severally responsible for acts subscribed by other Minister. Furthermore, Ministers who authorize the expenditure of funds contravening the provisions in the Law or the Constitution may be held liable for the reimbursement of those funds and guilty of embezzlement.

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on utility regulation, the Courts and the Antitrust Commission, another semi-judiciary entity, were the main force behind the almost total deregulation of the long distance market by siding against an initial government determination.

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IV. Utility Regulation and Antitrust Reforms The reforms of the utility sector started early in the Pinochet period. They were undertaken in the shadow of the antimonopolies statutes that were passed as one of the first acts of the Pinochet regime in December 1973 (Decree Law 211, hereafter DL 211). The Chilean antimonopolies statute has three components that became a crucial determinant of the evolution of the utility sector: first, it prohibits the granting of any exclusive monopoly right; second, it limits anticompetitive behavior; and third, it creates a complex institutional framework and procedure to resolve antitrust complaints raised by both the government and the private sector. Its prohibition of exclusive monopoly rights implies that unless expressly stated by sectorial laws, there are no exclusive service territories nor exclusive areas of operation. Thus, from 1973 on, there was free entry into all areas of economic activity, including the utility sector. Furthermore, private investors were able to use the mechanisms stipulated in the Decree Law 211 to force themselves in, and to trigger regulatory changes that limited the power of the incumbent firms. In the utility sector properly, the reforms started with the creation in 1977 and 1978 of specialized regulatory agencies for the electricity and telecommunications sectors (the CNE and SUBTEL respectively). Table B:1 provides the milestones in the utility reform process. As the Table describes, the reforms involve both a change in the regulatory frameworks, as well as the restructure and eventual privatization of public companies. Because the antitrust reforms are so important to understand the evolution of the utility sector, we detail their nature first. Also, because the reforms of the electricity sector were the first and to some extent, the most radical ones, we will analyze them in more detail than the reforms in the other sectors.

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1973: 1977: 1978: 1979: 1981: 1982: 1982: 1985: 1985: 1987: 1987: 1987: 1988: 1988: 1989: 1989: 1989: 1989: 1990: on local and long distance service 1991: 1992: 1993: 1993: and ENTEL

MILESTONES IN CHILE'S UTILITY SECTOR REFORM DECREE LAW No. 211: Antimonopolies statute, creates Antitrust Authorities LAW No. 1.762: Creation of SubSecretary of Telecommunications (SUBTEL) LAW No. 2.224: Creation of the National Energy Commission (CNE) ANTITRUST COMMISSION opens telecommunications equipment market to competition Beginning of PRIVATIZATION of electricity distribution assets DFL No.1: Regulatory Framework for the Electricity Sector LAW No. 18.168: General Telecommunications Law MINISTERIAL DECREE: Organization of Central Dispatch Center Beginning of PRIVATIZATION of electricity generation plants 1987: DFL No.1: Reform of Telecommunications Law, introducing price setting framework PRIVATIZATION of CHILMETRO (largest distribution company) PRIVATIZATION of CHILQUINTA PRIVATIZATION of CHILGENER (2nd largest electricity generator) DFL No. 70: Price setting Framework for water companies PRIVATIZATION of CTC (the main local telephone company) PRIVATIZATION of ENTEL (the main long distance company) PRIVATIZATION of ENDESA (main generator) CTC and other local exchange companies request long distance licenses ANTITRUST COMMISSION allows the participation of telecommunications companies in both SUPREME COURT requires from the Antitrust Commission a reconsideration of its 1989 decision MINISTERIAL DECREE: Regulatory framework for granting water company licenses ANTITRUST COMMISSION prohibits partial joint ownership of CTC and ENTEL. ANTITRUST COMMISSION upholds prior decision to allow telecommunications companies to SUPREME COURT upholds Antitrust Commission 1992 blocking of partial joint ownership of CTC 1994: LAW 3A: Introduction of the multi-carrier system for long distance telecommunicationsTable B:1

local and long distance services, requiring the introduction of a multicarrier system

provide both local exchange and long distance services based on a multi-carrier system

Reforming Antitrust
Although prior to the passage of DL 211 there were antitrust statutes in Chiles books, they were, as in most of Latin America, inoperative and ineffective. As mentioned DL 211 made three important changes: first, it deemed criminal all anticompetitive actions (Arts 1 and 2); second, it prohibited the granting of a monopoly license to a non-governmental entity in any area of the economy (Art 4); and third, it created a complex institutional framework to resolve antimonopoly claims by both the private sector and the government. The latter was a crucial feature to

G Guerrero

For a discussion of Chiles antitrust statutes in a comparative perspective see Lopez Echeverria (1986). See also (1979).

In its Art 4 it specifies that only through specific legislation can a particular activity be reserved for governmental entities.

April 1, 1995THE INSTITUTIONAL FOUNDATIONS OF ECONOMIC REFORMS Page 19

implement the first two. Indeed, in the utility sector, companies, both new and old, utilized DL 211 to attempt to enter into de-facto closed markets. As the telecommunications case will show, the DL 211 also provided a measure of regulatory flexibility that would not have existed otherwise. DL 211 created four entities: The Office of the National Economic Attorney General, the Regional Preventive Commissions, the Central Preventive Commission and the Resolutive Commission. These institutions, however, seem to have been designed so as to limit the ability of the government and legislators to influence the outcome of antitrust cases. Three features are important here: first, a decentralized appointment process (including random appointees), second, the rotation of membership in the commissions so that no easy quid-pro-quo could develop between politicians and commissioners, and third, the design of a complex decision making process. Let us first focus on the appointment procedures. The National Economic Attorney General (NEAG) is appointed, as the Comptroller General, for an indefinite temr by the President and cannot be removed. Each Regional Preventive Commissions is chaired by the Regional Economic Secretary, and it is composed of three other members, one appointed by the Governor of the Region, one appointed by the Regional Development Council, and one appointed by the Presidents of the Neighborhood Committees. The Central Preventive Commission is composed of five members. The chair is a representative of the Ministry of Economics, and the other members are: a representative of the Finance Minister, two university professors (a lawyer and an economist) appointed by the Council of University Rectors, and a representative of the Neighborhood Committees of the metropolitan area. The Resolutive Commission is composed of five members. It is chaired by a Supreme Court Justice (appointed by the Court itself), and the other members are appointed in the following manner: the Ministers of Economics and Finance each appoints one, a Law School Dean and an Economics Department Chair. The latter two are randomly selected from the list of law schools and economics departments. Membership in all antitrust commissions is for two years. The appointment process, then, limits the ability of the government to dictate antitrust policy. In particular, although the government has two representatives in the Resolutive Commission, the other three are appointed in essentially a random fashion. Similarly, the Preventive Commissions have a heavy regional flavor, with the government always controlling less than half the appointments. Thus, the appointment process to the antitrust commissions is consistent with the intent of creating indepedent entities. Another important feature of the antitrust authorities that strengthens their independence from the central government is their formal interaction and the potential for subsequent appeals. First, the NEAG is in charge of investigating violations of the antitrust statutes. It can

The exact term is Fiscala Nacional Econmica. The NEAG can only be removed by a process instituted by the Comptroller General.

April 1, 1995CORBO, LUDERS AND SPILLERPage 20

investigate on its own, or at the request of a Preventive Commission. It can request that the Preventive and Resolutive Commissions take actions under their responsibilities. It can participate in front of the Resolutive Commission in support or against a decision by the Regional Preventive Commissions, and similarly can participate in front of the Supreme Court in favor or against a resolution by the Resolutive Commission. The Regional Preventive Commissions are in charge of resolving antitrust issues in their regions, while the Central Preventive Commission deals with issues that arise in the metropolitan area or that involve more than a region. Any person, including the government or the NEAG, may file a complaint in front of a Preventive Commission, who then will undertake an investigation and will issue an order. A type of order that is of particular interest in the utility sector is that, following a determination that there is no free competition, the Commission may require from the Ministry of Economics the imposition of regulations on the supply of particular good or service. All decisions of the Preventive Commissions can be appealed to the Resolutive Commission. The latters decisions are not appealable, except when such decisions impose monetary penalties, require the modification of the statute of a corporation, or blocks a person from belonging to a particular association. In these cases, the decision of the Resolutive Commission can be appealed to the Supreme Court. If DL 211 would have stopped in Art. 4, then it would not be that different from the previous antitrust statutes, although Art. 4 would have raised substantial problems to the utility operators as their licenses would have lost the exclusivity. What made Arts 1 through 4 so important was the creation of a complex system of checks and balances concerning competition issues. As we will see, this process was used several times
b by both the government and the private sector, and had a drastic influence in the opening of the telecommunications sector to competition.

Articles 1-4 determine what is anticompetitive and that there can be exclusive monopolies or licenses.

April 1, 1995THE INSTITUTIONAL FOUNDATIONS OF ECONOMIC REFORMS Page 21

Reforming the Electricity Sector In 1980 the chilean reformers set up the basis for the first competitive market in wholesale and retail electricity in the world. Following a blackout-ridden winter in 1979, the National Energy Commission (NEC) initiated studies to reform the electricity sector. In 1980 the NEC developed a novel regulatory regime whose main purpose was to let market forces determine prices, quality and investment levels, while restricting the government to regulate those parts of the sector in which competition may not fully develop, namely, transmission and distribution. In September 1982 the regulatory framework was passed as law through DFL No. 1. DFL No.1, with small variants still sets the framework for competition and regulation in the electricity sector. The reforms of the electricity sector were drastic: ENDESA, the main generating company was broken in several smaller generating companies, while CHILECTRA, the main distribution company, was broken in 19 distribution companies. A pool company (Center of Economic Dispatch -CED hereafter) was created as a large generators' club. A wholesale market was created whereby generators could sell under long term

This section is partially based in Spiller and Viana (1994). The blackouts were partially triggered by CHILECTRAs introduction of a preferential winter residential electricity tariff (winter is the period of peak consumption). That special tariff drastically increased the use of electric heating devices in the Santiago-Valparaso region. One of the first steps in the regulatory reform was the elimination of the preferential winter tariff and its replacement, in 1980, by a residential winter tariff with a 100% surcharge over 1979 rates. Eventually, because of negative public response, this tariff was applied only to those consuming more than 250kWh per month during the winter period. See Bernstein (1986) and Philippi (1991). 2 The NEC was created in 1978, but only in late 1979, following the disastrous winter and the resolution of pricing conflicts between ENDESA and CHILECTRA, did the agency undertake its first studies that led to the introduction between January and October 1980 of the new pricing schemes. See Bernstein (1986). b Prior to 1980, electricity prices were based on the electricity law of 1931, with the amendments of 1959. The 1959 amendments provided for a maximum rate of return on fixed assets of 10%, and introduced the automatic revaluation of fixed assets. From 1959 on, electricity prices were determined by a Tariff Commission, composed of representatives of the President, the enterprises, consumers and headed by the Director of the Office of Electric Services. During the 1960s, though, the companies seldom reached the maximum allowed rate of return. The sector's financial situation deteriorated substantially during the period 1970-1973, as no price adjustments were allowed even in the face of hyperinflation. In the period 1974-1979, attempts were made to improve the financial situation of the companies. This process culminated with the creation of the CNE and the development in 1980 of the current regulatory regime. w DFL stands for Decree with Power of Law. This instrument is used when a law specifically delegates to the executive to issue a decree legislating on a particular topic. This decree, then, can only be amended by the legislature, except when the DFL itself stipulates that parts are to be regulated by further decrees. t It is interesting to mention that none of those that develop the reforms were economists. Indeed, the three individuals most connected with the creation of the competitive wholesale market and the regulatory framework which will be described in some detail below were engineers. At the time, energy economists at the World Bank and other lending institutions were not particularly supportive of such drastic reforms. i The CED was created by a 1985 decree that regulated DFL No.1. The Decree required from large generators (with at

April 1, 1995CORBO, LUDERS AND SPILLERPage 22

contracts to large buyers, with quantity differences being settled at the relevant hourly nodal price. Sales to the distributing companies were to be regulated based on a very specific model that was used to forecast short term marginal cost of generation. This price was to be recomputed every six months based on a very specific formula. The law also stipulates that if the regulated price differs by more than 10% from the competitive price, then the regulated price has to be adjusted up or down towards the competitive price. As a consequence, regulated prices have an anchor in the competitive market place, a main tenant of the "yardstick competition" concept. Transmission and distribution charges are also regulated. Because competition in those two sectors was not expected to develop, the DFL No.1 regulates in a very specific way the maximum prices for distribution. Investments in generation became free from regulation, with investors being able to undertake any type of project without requesting permission from the NEC. The DFL No.1, then, grants the NEC a very small planning role. Transmission and distribution projects require of a license and the DFL No. 1 specifies the specific process required to granting such licenses. These licenses have no term and are not exclusive. From a policy, and even academic, perspective, the DFL No. 1 1982 was innovative and path breaking in many respects. a) It set up the basis for the first competitive market in electricity. b) It specified in a precise fashion the parts of the sector that were to be subject to regulation and those that were not, thus limiting the potential for opportunistic reregulation by the NEC. c) It implemented for the first time the concept of

least 2% of the system's installed capacity) that are interconnected to a grid to belong to the systems CED. Small generators that were also intereconnected would then enter into contracts with the large generators, whereby the latter would operate the formers' plants and settle their transactions at the nodal spot price. Thus the large generators may operate their own mini-pools. Large generators that do not want to belong to the CED can also opt to enter into similar contracts with other large generating companies. The Decree also determined in excrutiating detail the way the CEDs are to operate and how they must be organized. For example, Art. 23, 2 reads: "By the instantaneous marginal cost of energy it is meant the cost, including the rationing component, that the whole electric system has on average during an hour to provide an additional unit of energy at the respective bus, considering the optimal operation determined by the CED." This, in electrical engineering jargon, represents the shadow value of energy at each node. There currently are two CEDs, one for the CIS and another for the northern system. t Initially, large buyers were those with more than 4MW of demand. The DFL No.1, however, reduced that threshold to 2MW. 2 This model takes into account the dependency of Chile's electricity system on the current, and forecasted hydrological conditions. Although the model looks complex to a lay person, the computer program that runs it is quite simple, as one year of data required half a minute of CPU time in a Digital Deck 10 computer. The model is a variant of a model previously developed and used by ENDESA. See Bernstein (1986). p See Shleifer (1985).
l laying

The law stipulates a specific, and complex, decision making process for hydro-based generating plants and for the of transmission and distribution lines, as long as these facilities require the taking of public or private property.

Initially, though, as all the generating park was in the hands of the public sector, the NEC took a more active role in reviewing those companies expansion plans. r Recall that contracts with users with more than 2MW demand were deregulated.

April 1, 1995THE INSTITUTIONAL FOUNDATIONS OF ECONOMIC REFORMS Page 23

"yardstick" regulation in the regulation of power sales to distribution companies. d) It implemented, also for the first time, a form of price cap regulation for the distribution companies. It stipulated that the maximum distribution prices (caps) were to be determined every four years by a method based on the "benchmark" competition concept. Individual firm maximum prices were to be based not on the company's costs but rather on those of an hypothetical efficient firm, computed at replacement level. Within the four year periods, prices were to be indexed. e) Finally, it set up "nodal" prices that vary by location taking into account system losses and expected constraints. These were all institutional innovations that although at the time were not widely appreciated by the academic community or by practitioners, their popularity has increased across the region. Indeed, the privatization and regulatory reforms of the electricity systems that are taking place in Argentina, Peru, and Bolivia closely follow what by now is the Chilean model. The comprehensiveness of the regulatory structure drastically limits the power of the regulator to deviate from what is specified in the law, granting the regulator very little discretion. Attempts to modify the regulations also face serious difficulties. Not only modifying the DFL No.1 requires a legislative act, but the multiplicity of companies participating in the sector makes legislative action difficult in the absence of consensus. Furthermore, attempts by the regulator to set prices not in accordance to the explicit regulations can be challenged in courts, and the DFL No.1 explicitly states that the affected companies can demand compensation from the government. Consider, for example, the process by which distributing companies prices are set every four years. First, the law specifies that such

Recall that the regulated price was to be confined within a narrow band set by the competitive price. Inside that band, prices were to be set based on a very precise list of instructions attempting to compute the future average short run marginal cost. The setting of these regulated prices could be appealed to the courts. m Price cap regulation became popular with the privatization of British Telecom in 1984. The price cap scheme was proposed by Professor Stephen Littlechild in 1983. See Littlechild, S. Regulation of British Telecommunications Profitability, 1983, London: H.M.S.O. For a general discussion of price cap regulation, see the Autum 1989 issue of the Rand Journal of Economics. . The NEC was instructed to contract out the computation of the replacement costs of the hypothetically efficient firm. The distribution companies could also contract out such studies. The NEC was further instructed to build a small set of hypothetical firm categories, so that distribution companies could be aggregated by type. There are three types, small, medium and large density, with two firms currently being in the "large" category. m Nodal pricing as the basis for the operation of competitive markets is a concept that became popularized with the work of Professor Fred C. Schweppe. See, for example, Schweppe, Caramanis , Tabors and Bohn (1988). For an assessment of o the use of nodal prices for pricing transmission see Oren et al (1995). In a sense, the experience in the United States with stalemate in telecommunications legislation is not that altogether different, except that the FCC and the state PUCs have more power to undertake unilateral action, subject, though to judicial review. Thus, in the United States, the telecommunications sector has evolved into a more competitive environment without a single legislative act. In Chile's electricity and as we will see in telecommunications and water as well, regulatory changes require costly actions by the legislature.

April 1, 1995CORBO, LUDERS AND SPILLERPage 24

computation will be done only every four years. It further stipulates the need for the NEC to contract out the computation of a putatively efficient firms costs, and to take into account the estimates provided by the companies own consultants. Discrepancies are settled either through the application of a particular formula or through arbitration. Compare this process to that in the UK whereby the Director General has the power to unilaterally set the new price cap level at any time and at any level. Objection by the companies may imply a reference by the regulator to the Monopolies and Merger Commission, without appeal. The reforms, then, built in commitment to the initial regulatory system, providing the basis for major private investments in the sector. Such institutional commitment, however, may not be feasible if the electoral rules and the organization of the legislature were such that they provide, as in UK-type systems, for single party control of both the legislature and the executive. In those cases, specific legislation -la Chile will provide very little commitment, as the party in government can almost unilaterally change the regulations. Thus, alternative ways have to be developed to provide regulatory credibility. The UK and other countries have found credibility in the use of very specific licenses. Not only the regulatory system was innovative and provided stability to the regulatory framework, but the restructuring of the sector was also a contributing factor. While in 1978 the electric system was based on two publicly owned integrated companies, ENDESA and CHILECTRA, today there are eleven power generating companies, 32 electricity distribution companies and two integrated companies, many of those being traded in the Chilean stock exchange. The average daily trading of eleven electricity companies in 1991 amounted to 45% of the value of all stock transactions in the Chilean stock exchange, with ENDESA accounting for 18.5% of that value and CHILGENER to 13.2%. (Philippi, 1991). See Table B:2. Table B:3 presents the distribution of ownership across the population for the largest companies. The Table shows that pension funds are the most important shareholders of the electricity companies. Employees have an important participation in Chilectra Metro,
w which has become a holding company of electricity companies both in Chile and in the surrounding countries.

For a discussion of the UK regulatory system, see Spiller and Vogelsang (1994a). Indeed, In the UK, regulatory frameworks have traditionally evolved through a series of acts of Parliament. For example, major gas regulation legislation was passed in 1847, 1859, 1870, 1871, 1873 and 1875. Similarly, water regulation legislation was passed in 1847, 1863, 1870, 1873, 1875, and 1887. Systematic regulation of electricity companies started in 1882, only four years after the inauguration of the first public demonstration of lighting by a public authority. The 1882 Act was followed by major legislation in 1888, 1899, 1919, and 1922, and culminating with the Electricity (Supply) Act of 1926 creating the Central Electricity Board. Spiller and Vogelsang (1993), and references therein for discussions of the evolution of utility regulation in the UK. t See Spiller and Vogelsang (1994). Since 1991 the number of distribution companies recently increased from 21 to 32 through the corporatization of several cooperatives.

ELECTRIC UTILITIES' STOCK TRANSACTIONS (FIRST SEMESTER 1991)


April 1, 1995THE INSTITUTIONAL FOUNDATIONS OF ECONOMIC REFORMS Page 25

UTILITY CHILECTRA CHILGENER CHILQUINTA COLBUN EDELMAG EDELNOR ELECDA ELECTRICID ELIQSA EMELAT EMELSA ENDESA ENERSIS PILMAIQUEN 15.3 89.1 2.0 5.6 0.3 2.4 0.9 4.6 0.7 1.2 2.8 125.0 49.8 9.2

US$ Millions 2.3 13.2 0.3 0.8 0.0 0.4 0.1 0.7 0.1 0.2 0.4 18.5 7.3 1.4 SOURCE: Philippi (1991).Table B:2

Share of Total In %

OWNERSHIP OF MAIN ELECTRICITY COMPANIES (In %; December 1990) <2> <1> OWNERSHIP ENDESA GENERAL PUBLIC PENSION FUNDS EMPLOYEES 3.3 FOREIGN FUNDS STATE TOTAL 0.0 100 OTHERS <3> 24.3 CHILGENER 38.8 26.3 1.5 7.3 0.0 49.7 100 CHILECTRA COLBUN METROPOL. 8.2 31.1 0.0 9.4 97.4 1.3 100 1403 1.3 - 0.0 29.0 28.3 0.0 - 0.0 0.0 0.0 42.7 83.0 100 100 864 4751 1738 17.0 CHILECTRA V REGION

TOTAL SHAREHOLDERS 51833 NOTES:

<1> Pehuenche, SA is owned by ENDESA (95.4%). <2> CHILECTRA METROPOLITANA is owned by Enersis. <3> Includes other legally stablished companies.Table B:3 This drastic restructuring of the sector was achieved by separating generation and transmission from local electricity distribution. For example, the distribution side of ENDESA was broken into several distribution companies each with coherent geographic and economic units, and they were subsequently privatized. Similarly, CHILECTRA was broken into three units, a generation and two distribution companies. See Tables B:4 and B:5 showing the main generating and distributing companies, and whether they used to be part of ENDESA or CHILECTRA. Table B:4 shows that in the Central Interconnected System (CIS), ENDESA still controls more than 50% of total capacity. Nevertheless the extent of divestment of ENDESA's generating capacity has been quite large, and since there are no legal entry barriers nor big economies of scale, there is no evidence that ENDESA has been able to exercise any significant market power in the wholesale market. Tables B:4

On the other hand, since ENDESA also is the main transmission company, substantial complaints have been raised

April 1, 1995CORBO, LUDERS AND SPILLERPage 26

and B:5 also show the extent of concentration in both generation and distribution that characterized the pre-1980s regime. The divestment of the larger companies was done through sales to the public at large, while the smaller units (less than 50 MW) were sold directly through public auctions (Philippi, 1988). The restructuring was innovative in several respects. First, although todays common wisdom is that there are no economies of scale in generation, that was not the case in the late 1970s. Second, the reformers also challenged the presumption that there were gains from consolidating distribution companies. Indeed, since the reform the number of distribution companies increased by 50%. Third, the emphasis in employee ownership and in diffuse ownership provided further safeguards to the political viability of the regulatory framework.

about its manipulation of the the price setting process for transmission. This has triggered several proposals for divestiture of ENDESAs transmission facilities and for changing the way transmission is priced. ENDESA has already divested parts of its transmission network and has also transfered its transmission assets to a fully owned transmission subsidiary.

April 1, 1995THE INSTITUTIONAL FOUNDATIONS OF ECONOMIC REFORMS Page 27

Chile's electricity sector has had a continuous expansion during the last 50 years. But as Table B:6 shows, since privatization the sector has had a rapid growth in generation capacity. Table B:6 shows the slower rate of growth in capacity during the 1970s and 1980s. The 1990s see, however, the highest growth rate since the expansion of the 1960s. ELECTRICITY DISTRIBUTION COMPANIES (1991) CUSTOMERS POWER SUPPLY COMPANIES ENERGY SYSTEM INSTALLED CAPACITY (In MW) OWNERSHIP (In 1,000) (MW) 1991 96 OWNER 139 THERMAL HYDRO CAPACITY (GWh) 1995 TOTAL

NORTE GRANDE INTERCONNECTED SYSTEM EDELNOR S<1> SYSTEM 140 TOTAL CENTRAL INTERCONNECTED SYSTEM CHILECTRA METRO P<2> 1106 NORTE GRANDE INTERCONNECTED SYSTEM CGEI P EDELNER CHILECTRA REGION V CODELCO SAESA EMEC FRONTEL CONAFE EMEL ELECDA EMELAT EMELARI 1855 ELIQSA EE DEL SUR 365 S<1> P<2> S<3> P 217 285 62 55 35 52 37 902

4741 96.2 471.0 95 132.5 699.7 na 1035* 250 550

1138 10.2 86.0 213 1119 471.0 0.0 328 00 0 289 0 00 140 184 132.2 0.3 271 689.2 10.5 195 187 187 90 90 511.5 245.1 29 0.0 500.0 26 0.0 14 0.0 48.6 22 0.0 8932 0.0 226.6 84.6 1087.53072.3 349.4

P<1> 114 ENDESA P<1> NORGENER P 110 P<1> 107 Self-generators P SUB-TOTAL P<1> 94 91

P<1> 84 CENTRAL INTERCONNECTED SYSTEM36 P<1> 46 36 ENDESA P P<1> 39 17 17 6 S<1> P<1> <5> 5 3 4 1699 P CHILGENER P<2> 35 P PEHUENCHE P<4> 16

1602.7 756.6 500.0 490.0 48.6 35.0 66.3 311.2 4159.8

1952.1 757 585 490.0 49 35.0 66.3 na 4137* 35 167 539

EE PTE ALTO P COLBUN 14 CE LITORAL P PULLINQUE P<1> 13 OTHERS 12 PILMAIQUEN TOTAL OTHERS Self-generators SUB-TOTAL AYSEN ISOLATED SYSTEM AYSEN ISOLATED SYSTEM EDELAYSEN S<1> 14 EDELAYSEN S<1> Self-generators SUB-TOTAL 2531

148 0.0 10.4 2.0 3.7 2.0 14.1

10.4 5.7 16.1

na na na

PUNTA ARENAS ISOLATED SYSTEM PUNTA ARENAS ISOLATED SYSTEM EDELMAG EDELMAG P<1> P<1> 36 Self-generators SUB-TOTAL TOTAL 46 72 45.6 0.0 47.4 0.6 93.0 0.6 1871.7 45.6 48.0 93.6 3097.5 na na na 4969.2

NOTES: 5172*

NOTES: <1> Previously owned by ENDESA <1> Previously owned by ENDESA <2> Previously owned by CHILECTRA <2> Previously owned by CHILECTRA <3> Self-generator P Private company <4> <5> Previously owned by CORFO, now owned by ENDESA Include 3 small companies.

S: S State owned company (CORFO)CORFO (state) controlled company P: Private company. *: Does not take into account self-generators. Assuming 1991 values for self generators and isolated systems, total 1995 capacity would be 5725.4MW. SOURCE: CNE, and Philippi (1991), installed MW has been estimated with a .6 load factor, B:4 energy values.Table Source: CNE, Philippi (1991), and SYNEX.Table 1988 B:5

April 1, 1995CORBO, LUDERS AND SPILLERPage 28

The regulatory system that was implemented in the early 1980s has produced an electricity system that brings prices close to long run marginal costs, that do not vary by end use, and that depend on the nature of the location. Since the introduction of the reforms, electricity prices, in US$, have remained relatively stable, falling during the early part of the 1980s and increasing at the end. See Table B:7. The offwinter average retail tariff in 1988 was approximately 0.08 US$/kWh (see Table B:8), while the average node energy price in Santiago at the 220V level was 0.032 US$/kWh, and the peak power node charge was 3.6 US$/kWh (Philippi, 1991).

April 1, 1995THE INSTITUTIONAL FOUNDATIONS OF ECONOMIC REFORMS Page 29

POWER GENERATION CAPACITY (MW)

POWER PUBLIC YEAR SERVICE SELFGENERATION GENERATION CAPACITY

1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995

179 202 390 541 600 887 1457 1879 2212 3094 3341 5172

308 355 385 451 543 566 686 741 728 873 968 na

487 557 775 992 1143 1453 2143 2620 2940 3967 4309 na

Source:

Philippi (1991), Synex.

Table B:6

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As Table B:8 suggests, though, customers haveELECTRICALchoices among different types of tariffs, some CHILE: AVERAGE substantial ENERGY PRICES*
CENTRAL INTERCONNECTED SYSTEM (US$ cent/KWh) NODE PRICE YEAR 1972 1973 1974 1975 1976 1977 1978 1979 1980 APR 81 OCT 81 APR 82 OCT 82 APR 83 OCT 83 APR 84 OCT 84 APR 85 OCT 85 APR 86 OCT 86 APR 87 OCT 87 APR 88 OCT 88 APR 89 OCT 89 APR 90 OCT 90 NOTES: *Since prices do not discriminate by user, this table reflects the most advantageous tariff choice per time of customer. <1> Load factor (LF)=0.6; Voltage level 220KV <2> LF = 0.457, low voltage <3> LF = 0.274, low voltage <4> LF = 0.548, high voltage <5> Hourly tariff, high voltage <6> Series until 1980 may not be comparable with post 1980. Source: Prices until 1980 from OLADE, various issues, from 1981 on, Philippi (1991).Table B:7 4.41 4.74 4.74 3.59 3.60 3.52 3.41 3.20 2.90 2.76 2.86 2.75 2.85 3.14 3.35 3.62 3.92 4.13 4.39 3.92 <1> RESIDENTIAL TARIFF (100KWh)<6> 1.93 1.52 1.53 2.54 3.04 4.61 4.53 6.28 8.96 11.70 12.24 12.25 8.80 7.59 7.45 7.37 6.18 6.70 6.40 6.53 6.48 6.58 7.06 7.34 8.23 8.78 9.24 9.84 8.77 9.35 9.85 9.87 7.55 6.55 6.45 6.32 5.28 5.61 5.37 5.52 5.44 5.55 6.01 6.28 7.28 7.84 8.25 8.79 7.83 10.12 10.67 10.69 7.55 6.55 6.45 6.32 5.31 5.79 5.56 5.70 5.62 5.73 6.19 6.45 7.60 8.19 8.62 9.18 8.18 PUBLIC LIGHTING <2> SMALL INDUSTRY <3> LARGE INDUSTRY <4><6> 0.72 0.65 0.61 1.21 1.70 2.91 3.05 4.26 5.11 6.31 6.68 6.68 5.52 4.87 1.78 4.67 3.84 3.97 3.78 3.91 3.81 3.93 4.29 4.53 4.78 5.18 5.45 5.80 5.17 5.00 5.15 5.16 4.02 3.41 3.37 3.18 2.65 2.82 2.74 2.90 2.83 2.95 3.29 3.59 3.97 4.33 4.56 4.85 4.32 AGRIC <5>

April 1, 1995THE INSTITUTIONAL FOUNDATIONS OF ECONOMIC REFORMS Page 31

TYPICAL ELECTRICITY TARIFFS CHARGED BY DISTRIBUTION COMPANIES (1986-1988, in US$) ELDENOR (Regions I & II) Fixed Energy Tariff Charge kWh Surchage month kWh month BT1 Metered up to 90 kWh/month .73 over 90 kWh/month 1.08 .088 .102 .87 .87 .08 .08 .16 .16 month max kW kWh monthmax kW Winter Charge Charge Charge ChargeCharge CHILECTRA METROPOLITANA (Santiago) (12/86) Demand Energy (6/88) FixedDemand

BT2 Monthly Contracted without peak limits partly peak usage 1.08 1.08 10.51 7.00 .058 .058 .87 .87 10.0 6.43 .046 .046 -

BT3 Monthly Maximum without peak limits partly peak usage 1.72 1.72 10.51 7.00 .058 0.58 1.61 1.61 10.0 6.43 .046 .046 -

AT2 High Voltage with Monthly Contracted without peak limits partly peak usage 1.08 1.08 6.74 4.34 .051 .051 .87 .87 6.08 3.93 .0396 .0396 -

AT3 Monthly Maximum without peak limits partly peak usage 1.72 1.72 6.74 4.34 .95 5.79 .051 .051 .051 1.61 1.61 2.41 6.08 3.93 .76 5.31 .0396 .0396 .0396 -

AT4 Off-Peak Tariff 2.52 Plus off-peak demand Plus peak demand -

SOURCE: World Bank (1988).Table B:8

That prices also vary substantially across locations can be seen in Tables B:9 and B:10. Table B:9 presents the average prices that ENDESA charged to public service distribution companies and to large private customers in 1986. First, we observe that large users get either the node peak power price or slightly

April 1, 1995CORBO, LUDERS AND SPILLERPage 32

above that, while the energy charges for large users is one or two percent higher than that charged to the distribution companies. Thus, large users' prices are indeed close to marginal costs. Second, there is substantial variation across regions. Geographical price distributions can further be seen by comparing different locations and type of tariffs to the levels in Valparaso, which is the load center of Chile. As can be seen in Table B:10, even in the CIS there are substantial differences across locations. These differences arise from the workings of marginal transmission prices.
TYPICAL TARIFFS CHARGED BY ENDESA FOR HIGH VOLTAGE CUSTOMERS (December 1986)

LOCATION

VOLTAGE

DEMAND CHARGE CHARGE US$/kW max/month

ENERGY US$/kWh

Public Distribution Companies Taltal Diego de Almagro San Isidro, Alto Jahuel Rancagua Temuco Valdivia Osorno Puerto Elviar Large Users Diego de Almagro San Isidro, Alto Jahuel Rancagua Valdivia Osorno 220 220 154 66 66 4.18 3.18 2.92 2.85 3.03 0.028 0.020 0.020 0.016 0.016 66 23 110 220 220 154 154 66 3.03 7.88 4.95 3.94 3.18 2.92 2.92 2.85 0.016 0.035 0.034 0.027 0.020 0.020 0.020 0.016

Note: Delivery points are ENDESA's substations. Additional charges may apply for other delivery points. Tariffs do not include value added of 20%. Source: World Bank (1988), Annex 15.Table B:9

Even though prices seem to be close to marginal costs, that has not stopped the private electricity firms from making reasonable profits. ENDESA, for example, has had positive profits, except for 1985, with the average yearly profit level since 1983 amounting to US$ 71 on less than 1,700 MW of installed capacity

April 1, 1995THE INSTITUTIONAL FOUNDATIONS OF ECONOMIC REFORMS Page 33

(in 1989). See Table B:11. The regulatory system has also promoted large investments by private electricity companies. In 1991 ELECTRICITY PRICES ENDESA, PEHUENCHE and CHILGENER had six investment projects (five of those involving GEOGRAPHICAL PRICE DISPERSION hydroelectric plants) for a total of US$ 1,830 million. These projects were to add 1,429 MW of istalled
NODE RESIDENTIAL PUBLIC SYSTEM <1> SMALL LARGE

capacity by PRICE of 1996. TARIFF the end This additional capacity represents an increase of a third of the industry's 1989 LIGHTING INDUSTRY INDUSTRY AGRIC installed capacity.
(100KWH) <2> <3> <4> <5> See, Table B:12. Since 1991, two coal and one hydro projects for a total of 448MW were initiated to be completed by the

NORTE GRANDE INTERCONNECTED SYSTEM end of 1997. Antofagasta 176 122 128 134 139 136 The restructuring process, PROJECTS UNDER CONSTRUCTION prices are closely related to long run marginal ENERGY then, has been quite successful. Electricity

CENTRAL INTERCONNECTED SYSTEM costs, private investment is taking place in all areas of activity (including hydroelectric plants), electricity companies are widely held and are daily (1991) La Serena 122 110 111 111 115 114 traded in the local stock exchange. The market is very dynamic, with contracts among generating, transmission and distribution companies and Valparaso 100 100 100 100 100 100 Santiago 100 95 102 104 96 92 their consumers taking new and varied forms. The regulatory system has sustained without much problems the financial crisis of the early 1980s, Concepcin 91 92 85 86 87 89 Puerto Montt 79 COMPANY/PROJECT AYSEN ISOLATED SYSTEM Aysen CHILGENER 175 145 ALFALFAL 150 Mw 79 77 134 160 Mw US$200 136 US$300 148 1991 (I SEM) 142
a and has shown to be resilient to government and interest groups pressures. CAPACITY (US$MILLIONS) PROYECTED DATE

86

86

88

83

79

HYDRO: PUNTA ARENAS ISOLATED SYSTEM THERMAL Punta Arenas NOTES: 77

1996 (II SEM) 80

72

56

ENDESA * Since prices do not discriminate by user, this table reflects the most advantageous tariff choice per time of customer. <1> <2> <3> <4> <5> Load factor (LF)=0.6; Voltage level 220KV HYDRO: CANUTILLAR LF = 0.457, low voltage HYDRO: LF = 0.274, low voltage LF = 0.548, high voltage Hourly tariff, high voltage PEHUENCHE HYDRO: HYDRO: 1983 1989 1990 106 Source: Philippi (1991). Table B:10 1991 (I SEM) 1994 (II SEM) 1986 1987 1988 PANGUE 144 Mw 400 Mw US$280 US$400 1991 (I SEM) 1996 (I SEM)

PROFITABILITY OF ENDESA PEHUENCHE 500 Mw US$500 (In US$ Millions) CURILLINQUE 1984 75 Mw US$150 1985

In 1989 the installed capacity of private firms was 2,902 MW, while that of public generating SOURCE: Philippi (1991).Table B:12 PROFITS -65 50 62 179 companies was only 586 MW. See 101 Philippi (1991). 33
104 Source: Philippi (1991).Table B:11

April 1, 1995CORBO, LUDERS AND SPILLERPage 34

Although the overall picture of the reforms is quite positive, there are some important problems with the regulatory framework, particularly as it relates to the pricing of transmission for competitive transactions and to the pricing of distribution. The former problem arises because customers located away from the center of consumption have to pay variable transmission charges in excess of marginal losses and constraints. As a consequence, local generators have very little competition for those customers, increasing their contract prices. This concern has triggered interest by the regulators in alternative pricing schemes for transmission. The latter problem is related to the fixed formula to arbitrate differences between the prices reached by the NECs and the companies consultants. The law specifies that for new firms such differences are solved through binding arbitration. For existing firms, though, such differences are settled based on a fix formula giving 2/3 weight to the values given by the NECs consultants and 1/3 to those given by the companies consultants. As a consequence, the prices given by the NECs and the companies consultants have diverged over time, with NECs consultant values going slowly down, while those for the companies going slowly up. The average distribution price, however, has remained relatively constant. Thus, there appears to be a gaming of the price setting system by both the NEC and the companies, which has triggered proposals for reform. The fact that the regulations concerning transmission pricing schemes are enshrined in legislation, implies that such modification will require substantial consensus among the electricity companies, limiting the potential for regulatory reform. This, then, is an example of the unavoidable tradeoff between flexibility and commitment. The Chilean reformers seem to have sided with commitment over flexibility. To summarize, Chilean regulatory and institutional changes of the early 1980s has dramatically changed the nature of the sector. It has brought prices closer to marginal costs, while at the same time has provided incentives for firms to invest in the three basic segments of the sector. The success of the reforms in motivating private sector investment and in aligning prices with costs is consistent with the nature of the reforms. First, the regulatory regime substantially limits regulatory discretion; second, the regulatory instrument chosen (very precise

For example, recently, generation and distribution companies have started to invest in transmission lines. The fact that the major electricity companies are widely held among small investors and pension plans may have also contributed to the stability of the regulatory system. For example, in 1989 two thirds of ENDESA's stocks were held by small investors (Philippi, 1991). See Table B:3. s For an discussion of this point, see Spiller (1995). There have been three settings of distribution values since the 1982 law. The first in 1984 and the other two four years apart. In the 1984 setting the average values differed by 5%. In the 1988 setting the values differed by more than 20% and in the 1988 revision they differed by more than 40%. See Agurto and Bernstein (1994). a On the other hand, the reform of the arbitration process for distribution companies may not be that difficult to undertake as it would simply imply eliminating the fixed arbitration formula and instead moving towards a binding arbitration as in the new firms cases. Given that no firm would naturally be hurt from such reform, it could take place following, or even, prior to the next round of price setting in 1996.

April 1, 1995THE INSTITUTIONAL FOUNDATIONS OF ECONOMIC REFORMS Page 35

legislation) is compatible with the institutional environment that limits the ability of the government to change legislation, and finally, those restrains are backed up by both diffused ownership of the electricity companies, and by an independent and strong judiciary that can limit regulatory and governmental deviations.

Reforming the Telecommunications Sector. As Table B:1 shows, the reform of the telecommunications sector was undertaken at the same time as that of the electricity sector. Indeed, the philosophical foundations of the regulation of both sectors is the same: freedom of entry into all areas of the sector, licenses required only for the taking of public or private property (and in the case of telecommunications, for the use of the spectrum), very minimal obligation to serve, and minimal government intervention in the sector. There were, however, two main differences in the implementation. First, the belief that telecommunications was an inherently competitive sector led the writers of the 1982 legislation not to introduce any stipulation concerning the regulation of prices. Although interconnection was required, the legislation left the terms of interconnection to be decided by the parties. Second, differing from the electricity sector, the government did not attempt to change the initial market structure, and hence did not restructure the two main telephone companies. Thus, competition started with two monopoly companies, one a local service (CTC), and another a domestic and international long distance provider (ENTEL). By 1982, then, Chile was the first country to introduce open competition in all sectors of telecommunications with minimal governmental regulation and with no restructuring of the sector. Such path- breaking status, however, did not last long, as in 1987 a major revision of the telecommunications law introduced a tariff setting process. Following a determination by the Antitrust Commission that neither local service nor long distance services were competitive, SUBTEL started the price setting process which culminated a year later, in September 1989, with the first regulated telecommunications tariffs. Thus, purely from a free-market perspective the 1987 reforms seem to be a
b backward movement towards price regulation.

CTC stands for Compa de Telefonos de Chile, and ENTEL stands for Empresa Nacional de Telecomunicaciones. A third government company was TELEX CHILE that was formed in 1982 taking over the telex activities of the post office. Several other private companies were formed during the late 1970s and early 1980s, but they held less than 5% of the overal revenue. D DESCRIBE CITE This is, indeed, the same policy recently taken by New Zealand. Cellular and other services were specifically exempted from the possibility of price regulation. The Telecommunications Law specified that if a sector is determined by the Resolutive Commission to be noncompetitive, then SUBTEL can regulate its prices according to a particular process determined in the law.

April 1, 1995CORBO, LUDERS AND SPILLERPage 36

A closer examination, however, suggests otherwise. Although since 1982 CTC and ENTEL, the main telecommunications operators, were allowed to set prices freely, in fact they set their prices following informal consultations with SUBTEL and the Economics Ministry (Galal 1994). Furthermore, the extent of competition in both local and long distance services did not develop rapidly. Although since the opening of the telecommunications markets five local companies were created, they tended to locate in areas where CTC did not have a license, or where it provided relatively bad service. The latter companies, however, faced growing difficulties, and by 1994 they achieved only 2% of the market (Corbo and Daz, 1994). Some of these growing difficulties could be related to normal market conditions, but others were related to the fact that interconnection agreements were not easy to develop. Indeed, all three companies obtained their interconnection agreements only following orders by the Antitrust Commissions. Thus, by 1987 it was clear that competition did not come to the telecommunications company. Furthermore, from the passage of the 1982 Act till 1987 the network was growing only slightly faster (at a 6.5% in terms of numbers of lines) than prior to the passage of the 1982 Act (a 3% rate). From 1987 on, though, the sector has been growing very fast (at more than 20% per annum). Indeed, by 1991, only
t three years after its privatization, CTC doubled its number of lines. See Table B:13.

Until their privatization, the two companies shares were held by CORFO, the governments development corporation. CORFO implemented a policy of segmentation of the two companies activities, moving CTC mostly to local service and ENTEL to long distance services. E Compaa de Telfonos de Coyhaique (TELCOY) and Telefnica del Sur S.A (CNT) operate in areas where CTC has no n operating license. These companies are Complejo Manufacturero de Equipos Telefnicos (CMET) which operates in parts of the metropolitan region and in other regions, Compaa Telfonica Manquehe (CTM) which operates only in parts of the metropolitan region, and SERTEL which operates in LOCATE. CTM, CMET, CTC, TELEDUCTOS and others also provide fiber optic services around the metropolitan region. p The law provided for interconnection agreements to be negotiated by the parties. Each time, though, the Antitrust Commission castigated CTC with undertaking activities that have tended to limit free competition in the telecommunications market and tended to limit entry... See, Resolution 151 of July 18, 1983.

EVOLUTION OF THE LOCAL NETWORK

April 1, 1995THE INSTITUTIONAL FOUNDATIONS OF ECONOMIC REFORMS Page 37

LINES IN TELEPHONES SERVICE DENSITY YEAR (1,000) (1,000) (1,000)

LINES PENDING TELEPHONE INSTALLED REQUESTS (1,000)

IN

SERVICE

(PER

100 PERSONS) 1960 116.9 2.7 1965 163.2 3.25 1970 240.9 4.14 1975 304.7 4.67 1980 360.3 5.36 1981 386.5 5.5 1982 397.5 5.43 1983 415.1 5.56 1984 456.4 5.92 1985 505.3 6.43 1986 527.8 6.59 1987 548.4 6.67 1988 591.5 6.99 1989 645.9 7.41 122.5 63.1 184.6 170.1 63.6 250.9 257.8 60.5 352.8 340.4 143.1 434.2 406.9 149.9 550.1 426.3 140.2 574.7 429.3 110.8 577.2 464.8 114.0 601.3 537.4 176.7 651.0 549.9 151.2 718.6 584.8 219.3 749.1 614.9 230.5 770.1 634.3 236.4 820.2 799.9 283.9 894.8

April 1, 1995CORBO, LUDERS AND SPILLERPage 38

The free-market approach to telecommunicatoins regulation, then, did not help develop the sector prior to 1987, although it seems to have worked just fine in electricity. The difference could not be explained by the different spead of privatization, as a look to Table B:1 shows that the main generating companies (CHILGENER and ENDESA) where privatized at roughly the same time as CTC and ENTEL. Nevertheless, competition and network growth arrived to wholesale electricity from the beginning (see Table B:6). Macroeconomic circumstances also do not seem to be behind the differential performance, as electricity generation capacity grew rapidly even during the early 1980s,

period characterized by slow economic growth. Although other explanations could also be raised to understand the lack of dynamism of the telecommunications sector, one feature seems important: the regulatory framework based on pricing freedom was not credible, particularly when the government also owned the two main telecommunications entities. The 1987 reforms, by formalizing the price setting process, reduced the government discretion in the determination of telecommunications prices, providing a more credible framework in which to invest. See Table B:14 for a description of the 1987 price setting process. As Table B:13 shows, CTC
We are aware, though, that electricity projects are lumpy and have a relatively long. On the other hand, the deregulation of electricity generation has drastically reduced the gestation life of new projects. See Augurto and Bernstein (1994). B Chile suffered one of the worst recessions in 1982/1983. See Table A:1. A particularly compelling alternative explanation is that, at the time, the government required a 100% dividend payout from all public companies, including CTC. This, however, cannot be a full explanation for the slow performance of the sector. First, by 1987 CTCs debt equity ratio was a mere 65%. It could have, even under public ownership, double its debt by increasing its debt equity ratio to 125% a ratio that it had in the past without too much of a problem. Such increase in debt would have allowed it a rapid increase in assets. Galal et al (1994, at 269). Second, even if CTC could not invest, if the pre-1987 regulatory framework provided was so credible, then such investment could have been undertaken by the private sector. The fact that the sector private sector did not invest much prior to 1987 suggests that the pre-1987 regulatory framework did not provided it with enough invesment incentives. Our reasoning is as follows: CTC doubled its size from 1988 to 1991. Essentially it created another CTC. Assume now that the 100% dividend payout was the main limit to CTCs investments and that the free pricing regime provided strong ex-ante investment incentives, then why is it that the private sector did not create a separate CTC prior to 1987. Instead the private sector built just 5% of the total number of lines. If the free pricing regime gave strong incentives, and macro-economic conditions were not blocking development, then it has to be that CTCs presence preempted the competing companies from investing. In other words, was it the fear of predatory investment by CTC that preempted the privately owned companies from expanding prior to 1987? But since CTC could not expand rapidly because of the 100% dividend payout policy, how could CTC predate? Indeed, the 100% dividend payout should have facilitated private sector entry by limiting CTCs response. Thus, the private sector had to face other constraints to its expansion. As we discuss in the text, the vagueness of the regulatory framework as it relates to interconnection was one important factor, but also the uncertainty about the future evolution of prices may have provided a strong disincentive for private sector development.

April 1, 1995THE INSTITUTIONAL FOUNDATIONS OF ECONOMIC REFORMS Page 39

aggresively responded to those incentives.


PRICE SETTING PROCEDURES STIPULATED BY THE 1987 AMENDMENTS TO THE GENERAL TELECOMMUNICATIONS ACT OF 1982

1. Demand is first estimated for each service/zone/firm bundle. 2. For each service, the incremental cost of development (LRMC adjusted for investment) is then calculated based on the concept of the efficient firm. The efficient firm is one that starts from scratch and uses assets only to provide that service. 3. Revenue is then estimated for each service such that the net present value of providing the service is equal to zero. This

revenue is the incremental cost of development. 4. If the incremental cost of development differs from the LRAC, efficient tariffs are increased in a least distortive way so

that firms make a fair rate of return. 5. each firm type. 6. each service. 7. Disputes among the companies and regulatros are settled by a committee of three experts, one appointed by each party Tariffs are calculated every five years. In the interim, prices are adjusted every two months using a Divisia index for The fair ROR is defined based on the capital asset pricing model. Thus, the law requires the computation of betas for

and a third by agreement.

Source: Galal (1994) and General Telecommunications Law of 1982, as amended.Table B:14

Table B:14 shows that the price setting process designed for the telecommunications sector is almost identical to that in the electricity sector. Prices are based on long run marginal costs of putatively efficient firms. Are recomputed every five years with indexation in the interim periods. There are, though, two important exceptions: the use of the capital asset pricing model to compute the cost of capital of the efficient telecommunication firm, and that disputes among the companies and the regulator are settled via a binding arbitration rather than through a fixed formula as in the electricity sector. Thus, again in 1987, the reformers chose to limit regulatory at the expense of regulatory flexibility. Although Table B:13 seem to show that the 1987 reforms had an important

The reforms of 1987 and the


April 1, 1995CORBO, all the predicted subsequent privatization hadLUDERS AND SPILLERPage 40

effects. The network expanded, prices for long distance services fell more rapidly, while those impact on the incentives to invest by both CTC for local service increased more rapidly, thus and ENTEL, the 1987 reforms do not seem to have drastically affected their ex-post performance. Table B:15 shows that both tending to eliminate the extent of crosssubsidization from long distance to local service. See Table B:16. Furthermore, the

companies profitability improved following the profitability of the long distance market passage of the 1982 Law, although it seems that provided a strong signal for potential the main beneficiary was ENTEL, as its return competitors, and in 1989 CTC and other local on net worth reached almost 40% by 1986. The exchange operators attempted to enter the long 1987 reforms also benefited ENTEL, as its profitability exceeded 40% in 1988 and 1989. CTCs profitability also increased a bit, but remained below 20%. But as Table B:15 shows, the companies ex-post performance started to improve not in 1987 but in 1982. Here is where Chiles institutional framework starts to have an impact
CTC

distance market by requesting from SUBTEL licenses to build and operate long distance facilities.
RETURN ON NET WORTH (In Percentages)

on the sectors development in an unexpected


ENTEL

way. Opposing the entry of the local exchange companies into the long distance market, SUBTEL requested in 1989 from the Central Preemptive Commission to consider whether entry of local exchange companies into long
1965 14.1 na 1960 7.9

distance is in the public interest. Although the


na

SUBTELs opposition to the local exchange companies integration into long distance was based on the potential 1970 10.7 anticompetitive impact that CTC could have on the long distance market. See Resolutive Commissions Resolution No. 389 of April 16, 1993. See Gaymer, et al (1993). na

1975 na

-8.6

EVOLUTION OF DOMESTIC LOCAL AND LONG DISTANCE TARIFFS


April 1, 1995THE INSTITUTIONAL FOUNDATIONS OF ECONOMIC REFORMS Page 41 LOCAL SERVICE

DOMESTIC LONG DISTANCE FLAT RATE Without taxes, in June 88 Ch$

Central Preemptive Commission sided with the government, it was rapidly reversed on appeal by the Resolutive Commission, which ordered that there should be no segmentation of the local and long distance services, and requested the introduction of a multi-carrier system whereby customers can choose their long distance provider. Thus, by 1989 Chile could have moved directly to long distance competition.
1972 2092.5 OPERATOR 80 KM 400KM 3250KM OPERATOR DDD COMM 1 MIN 1 MIN 1 MIN

1985 Ch$ per line

MIN MIN MIN

DDD OPERATOR RESID 3 MIN 3 MIN 3 MIN

DDD 1 1 1

1970 3342.2

1971 2610.8

1973 1575.6

1974 3063.3

1975 2848.0

1976 1942.7

1977 2346.1

1978 2868.0 246.44 382.20 1979 2653.2 265.09 411.23 1980 2806.3 180.90 243.66 1981 2663.3

1243.9 175.03 557.04 1799.71 971.7 175.03 557.04 1799.71 778.7 175.03 557.04 1799.71 360.9 174.41 555.25 971.77 906.4 191.32 620.89 984.20 842.6 163.37 530.82 841.67 576.0 131.76 429.43 679.14 694.1 144.94 445.79 691.35 848.6 80.15

785.0 86.21

830.3 80.11

788.0 83.14

April 1, 1995CORBO, LUDERS AND SPILLERPage 42

ENTEL, however, appealed to the Supreme Court which, in 1990, requested from the Resolutive Commission a more in-depth study of the technical conditions that would allow for Competition for long distance has had, so far, the expected results. First, twelve fair playing conditions, including the supervision of interconection quality (Gaymer, et al, 1993, at firms requested long distance licenses, and six firms entered the market by late September. 13). The Resolutive Commission took three years to study this issue anew, and, in 1993 it upheld its prior decision, and requested from the government the implementation in less than eighteen months of the multicarrier system. The system was introduced in late August 1994 outside
Following a hectic advertising campaign by all the long distance operators, prices of long distance services fell to a third or half of ENTELs prices prior to September 1994. See Table B:18. Also, as Table B:19 shows, ENTELs market share more than halved overnight. Even without

Santiago and a month later in Santiago. Prior to its introduction, and to some extent reflecting the strong pressure exercised by ENTEL, Congress amended the General Telecommunications Act
percentage of the market did not materialize, as CTC is still the third largest long distance carrier with less than 30% of the market. The

including public telephones, its market share did not to reach 50% by December 1994. Also, at least so far, the fear that CTC will capture a large

limiting for the next five years each operators market share in the domestic and international long distance market. Those carriers affiliated to local exchange companies (mostly CTC) were subject to stringer restrictions. See Table B:17. The Table shows the nature of the bargain: CTC is initially limited to a 35% of the long distance market, while ENTEL is required to initially
competition in the long distance market, it does not affect the extent of competition in local services. This is the next battlefront in the Chilean telecommunications wars. As with the introduction of long distance competition, competition at the local exchange will require further determination that both local and long distance services were not competitive. While the multi-carrier system improves upon the extent of

introduction of the multi-carrier system, then, completed the first round of reforms that started in 1987 with the Resolutive Commission

relinquish at least 30% of the market. But the market share restrictions also provides CTC with some protection from competition from ENTEL. If ENTEL decides to enter into local service
i in front of the antitrust authorities and the courts.

refinements in the regulatory framework, which, given the constraints involved in the regulatory scheme, will have to wait the results of litigation

during 1995 it has to relinquish 80% of its current long distance market share, or 50% more than if it stays out of the local service market. Thus, Law 3-A reflects a particular bargain struck among the companies that allowed the implementation of the Resolutive Commission. Although ENTEL lost at the Resolutive Commission, litigation provided it with 5 years of delay.
MARKET SHARE RESTRICTIONS IN THE LONG DISTANCE MARKETS DOMESTIC LONG DISTANCE DISTANCE YEAR 1995 70% 1996 65% 1997 45% 55% 70% 60% 30% 40% AFFILLIATED 35% NON AFFILIATED 80% AFFILIATED NON AFFILIATED 20% INTERNATIONAL LONG

Apart from CTC and ENTEL, Chilesat (the owner of CHILE Telex) and VTR (the owner of CNT and of TELCOY) 60% were already providing long distance1998 telecommunications services. New entrants include Bell South and Iusatel. CNT 60% 60% na na also started providing long distance services. a El Mercurio, 1/13/95, B20, estimates that without counting public phonesLaw 3-ATable B:17 the majority of the outgoing Source: (where CTC has calls) and private lines, ENTEL has 46.2% of the market, CHILESAT 30.6%, CTC-Mundo 11%, VTR 7.4%, Bell South 2.4% and CNT-Carrier 2.4%.

April 1, 1995THE INSTITUTIONAL FOUNDATIONS OF ECONOMIC REFORMS Page 43

ADVERTISED TARIFF RATES IN EL MERCURIO PER MINUTE, US$ (Average per month)

9/94* LDN/D LDN/N LDI/USA LDI/OTHER 2.676 1.602 0.497

10/94 0.047 0.017 0.407 0.607

11/94 0.028 0.026 0.390 0.461

12/94 0.040 0.016 0.328 1.285

1/95 0.083 0.059 0.428

Notes: * ENTEL tariffs, prior to the introduction of the multi-carrier system. LDN/D: national long distance, day time LDN/N: national long distance, night time LDI/USA: international long distance, USA LDI/OTHER: international long distance, other countries.

Source: own survey of El Mercurio.Table B:18 The introduction of the multi-carrier is an excellent example of how the original design of a system of checks and balances in utility regulation limits the ability of the government to tightly control the evolution of the industry. Indeed, the participation of the antitrust authorities reversed an original position of the regulator against vertical integration. The participation of the Supreme Court, another part of Chiles complex system of checks and balances, delayed the de-facto deregulation of long distance by four years. This seems to be another

Recall that the law explicitly granted the right to appeal to the Supreme Court decisions of the Resolutive Commission Anti to few specific cases, involving, among other issues, changes in the statutes of companies, as seems to have been the case here. c Indeed, CTC complained bitterly about what seemed to have been the manipulation of the system by ENTEL. See, the presentation by Mr. Germn Ramajo, the Executive President of CTC to a conference on Telecomunication in Chile: Vertical Integration, Free Competition, June 1992, entitled Telecomunications in Chile: The True and False Dillemas.

April 1, 1995CORBO, LUDERS AND SPILLERPage 44

example of the reformers choice of credibility over flexibility. This time, as may often be the case, credibility came at a cost. PARTICIPATION OF CARRIERS IN THE LONG DISTANCE MARKET (In percentage points)

SEPTEMBER/NOVEMBER 1994 DECEMBER 1994 CARRIER INTERNL ENTEL 35.93 CHILESAT CTC-M 25.15 VTR 13.15 CNT-C 0.06 BELL SOUTH IUSATEL 0.00 1.70 0.00 2.50 0.10 1.96 0.00 1.42 1.90 0.60 0.33 6.00 11.30 7.55 22.10 28.10 24.60 13.70 25.44 27.05 24.30 40.2 47.3 36.67 DOMESTIC INTERNL DOMESTIC

Source: El Mercurio, various issues.Table B:19